Learning the right lessons

Saw a piece earlier in the Guardian about Steve Keen, the Australian econonmist who seems to have been more right than most on the crisis and actually saw it coming.

Larry Elliot has a good piece in The Guardian today

and in particular:

Keen's argument is that the sovereign debt crisis is merely a symptom of the real cause of the problem: an exponential increase in private debt as a share of national income. In the early stages of a credit cycle, the private sector borrows to fund investment that pays for itself, but in the euphoric bubble phase borrowing is used to speculate on rising asset prices. Debt grows much faster than income but those borrowing the money assume they will be able to pay off what they owe from the rising capital value of their assets. This model of growth, in other words, is no more than a gigantic Ponzi scheme, named after the fraudster who paid out investors with money raised from the next wave of suckers.

The figures are quite startling. In the US, for example, private debt was 45% of national output (gross domestic product) in 1945. By the peak of the boom in the last decade, it was 300% of GDP, and has subsequently fallen to 265%. Over the same period, public debt has risen by 30 percentage points, softening the blow of the private-sector de-leveraging.

Britain has followed a similar pattern: during the economic upswing, individuals used their homes as cashpoints, withdrawing £300bn in equity as property prices rose. Since the crash, they have taken advantage of low interest rates to reduce their indebtedness. Equity repayment has been a little more than £50bn, suggesting this process may have some way to go. The global economy is not going to return to sustained growth until debt is significantly reduced.

One way of doing this is through "nature's cure": accepting that it will take time for the debt hangover to wear off. In the meantime, governments also need to put their house in order, reducing their borrowing so that interest rates can stay low and so that finance ministries build up sufficient ammunition to deal with any future crises. This option does, however, mean that the depression will continue for many years, because the result of the private and public sectors de-leveraging simultaneously is a hefty fall in aggregate demand.

In the US and the UK, quantitative easing (QE) has been deployed in an attempt to prevent private sector de-leveraging leading to a prolonged and deep contraction. Asset purchases by central banks boost the balance sheets of financial institutions and drive down the interest rates on government bonds, making other forms of investment more lucrative. The idea is for the money created by QE to flow out of the banks and into the wider economy.

Given the amount of money that has been created through asset purchases, the impact on growth rates has been disappointing. This is perhaps not all that surprising, given the desire of banks to hold more capital and the reticence of a debt-saturated private sector to borrow more. Ironically, the one bit of the economy that ought to be benefiting from QE – the small businesses in need of working capital – is still struggling to get the finance it needs.

Oiling the wheels

Keen says the solution to this problem is for governments to change dramatically the balance between fiat and credit money in the economy. Fiat money is the cash directly created by governments; credit money is created through a process known as fractional reserve banking, in which banks can lend more money than they hold as reserves. The assumption currently is that repeated doses of QE will oil the wheels of the fractional reserve-banking machine.

But by increasing the quantity of fiat money, Keen says this process could be circumvented. What should happen, he says, is that governments should give the public a big dollop of cash. Those that had debts would be obliged to use the money to pay them down; those that didn't would be able to spend the money however they wished. The result would be lower debt levels and greater spending power.

A more radical version of this idea would be a debt amnesty for those gulled into borrowing more than they could afford during the bubble years.

This, though, is not a realistic option: it would be seen as unfair by those who did not get into debt and it would be strongly opposed by the banks, many of which would go bust as a consequence. One thing we have discovered during the crisis (not that there was much doubt about it) is that the lobbying power of Wall Street and the City of London is immense. If they can head off the threat of a Tobin tax then they would certainly be able to nix a debt jubilee.

The attraction of Keen's proposal is that it attacks the root cause of the problem while at the same time offering to shorten and alleviate the cold turkey as individuals try to kick the debt habit. Rising household incomes would spur consumption – the biggest component of GDP – and would encourage those companies sitting on big cash piles to invest rather than hoard.